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January 6, 2006

Not Created Equal

S&P 500 ETFs Aren't All the Same

All funds that track the Standard & Poor's 500 index are not created equal.

The exchange-traded Rydex S&P Equal Weight Fund (RSP) offered by Rydex Investments is an exception. Every stock in its portfolio carries the same weight.

That makes the ETF different from most S&P 500 index funds, which are market-cap weighted, meaning that the biggest companies account for a larger chunk of assets than smaller ones.

Funds like Rydex's can outperform conventional S&P index funds when small and mid-cap stocks are in favor, as they have been in recent years.

"That's the principal advantage, I think, that stands out," said David Blitzer, the chairman of the Standard & Poor's committee that decides what stocks are added to or deleted from the S&P 500.

Steve Sachs, Rydex's director of trading, maintains that the Equal Weight Fund also provides greater investment diversity because it gives each stock the same shelf space.

Because the proportion of each company in the S&P 500 is tied to its market capitalization, the biggest companies can heavily affect the index's performance, he said. "You don't have that issue" in an equal-weighted index fund. You're allowing more of the portfolio to help you out, as opposed to just a handful of names."

Also, the equal weight index that the Rydex ETF tracks offers greater exposure to undervalued stocks, according to research conducted by Standard & Poor's, which developed the index with Rydex.

Conversely, a fund tied to an equal-weighted index can falter when large companies lead the market. In the last half of the 1990s, for example, this kind of fund "would have gruesomely underperformed" a cap-weighted S&P index fund, Blitzer said.

To complement the Equal Weight Fund and to give investors a way to own the largest American companies, Rydex this year launched the exchange-traded Russell Top 50 Fund (XLG), a cap-weighted index fund.

Another potential disadvantage of equal-weighted index funds is their need to be periodically rebalanced because of stock price fluctuations, which can drive up fund expenses, Blitzer said.

The Rydex fund is rebalanced quarterly. But its ETF structure holds down transaction costs, said Sachs. Brokers and other financial intermediaries who sell the fund can make in-kind exchanges, trading shares of the ETF for blocks of underlying stocks, he explained.

This also cuts down on capital gains distributions, said Sachs, who added that the Rydex ETF has not made any since its inception in April 2003.

The $1.3-billion Rydex fund, which has a 0.40% expense ratio, gained 6.78% in calendar 2005.

By comparison, State Street Global Advisors' S&P Depository Receipts (SPY), the largest ETF that shadows the performance of the cap-weighted S&P 500, returned 4.82% during the year, while the index gained 4.91%. The fund has an expense ratio of 0.11%.